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J.KAU: Islamic Econ., Vol. 22 No. 1, pp: 121-143 (2009 A.D./1430 A.H.)

121

Home Financing through the Musharakah Mutanaqisah

Contracts: Some Practical Issues

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak

Associate Professor and Senior Academic Fellow respectively at the

Department of Business Administration, Kulliyyah of Economics and

Management Sciences,

International Islamic University Malaysia, Malaysia

[email protected] - dzuljastri @iiu.edu.my

Abstract. The authors compare the al-Bay’ Bithaman Ajil (BBA) and

the Musharakah Mutanaqisah Partnership (MMP) contracts. The

BBA, a murabahah contract, was argued to be problematic and even

unIslamic for long-duration contracts. The MMP contract which is a

combination of musharakah (partnership) and ijarah (rental) contracts

was argued to be a more appealing alternative. In the MMP, the equity

of the financier diminishes progressively while, in accordance, the

equity of the customer grows. Unlike for the BBA contract, scholars

are consensus on the Shari’ah permissibility of the MMP contract. A

mathematical derivation for the MMP showed that the formula for the

MMP to be similar to the formula used in conventional loans but

nonetheless with the interest rate replaced with the rental rate.

Therefore, one major advantage of MMP was argued to be that it can

avoid interest (riba) totally. Also, unlike under the BBA, the balance

of financing, at any point in time, never exceeds the original price of

the asset. Nevertheless, some practical issues need to be addressed

particularly the means of estimating the rental rate, tax issues, defaults

and asset value appreciation. This paper discusses these issues. When

not profitable for the banks, when rental rates fall short of interest

rates, the MMP can be implemented through cooperatives, which can

be also an investment avenue for members.

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 122

1. Introduction

Meera and Abdul Razak (2005) argued the Musharakah Mutanaqisah

Partnership (MMP) contract as a better Islamic financing alternative for long

durations compared with the al-Bay’ Bithaman Ajil (BBA) contract. While the

BBA is popular in countries like Malaysia, Indonesia and Brunei, it has proven

to be quite unsatisfactory to the customers and bankers.

Customers are particularly not happy when it comes to early redemption or

in the event of default. In these cases, the BBA contract always carries a higher

financing balance compared to the conventional loan of similar APR. The recent

Affin Bank vs. Zulkifli is a landmark case, (ISRA Monograph Series, 1:2009)

Appropriately, the Middle Eastern Shari’ah scholars disapprove of the BBA

contract, citing that it is similar to the conventional loans.

For the bankers, the BBA fixed financing mode brings about liquidity

management problems. This is because its cost of funds, particularly the deposit

rate is based on floating rate while its income is predominantly based on fixed

rate murabahah and ijarah contracts where the rate is fixed. This mismatch in

duration can be much of concern and hence many Islamic banks have resorted

to ‘mind boggling’ profit rate swaps(1)

to solve this. Generally the Islamic bank

would swap its fixed rate murabahah cash flows for a floating rate cash flow to

match its cost structure. Recent innovation to the BBA by allowing it to be

based on variable rate is also meant solve this mismatch.

In summary, the BBA home financing, can be said to be almost similar to

the conventional financing but the customer is likely to end up with higher

financing costs in case of early redemption or defaults.

Due to arbitraging activities, the BBA has converged to the conventional

mode where the computational formulas are similar to the conventional and

where the profit rate tracks the market interest rate. Instead of charging the

customer interest, financiers charge a profit rate that is dependent on the market

interest rate.

To address the above issues, Meera and Abdul Razak (2005) argued for the

MMP as a better alternative to the BBA.

(1) The profit rate swap is nothing other than interest rate swap. It is mind boggling to the

Shariah scholar because it involves the transaction where two parties would lend money to

each other for the same principal amount but at different rates – one floating, one fixed.

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

123

2. The Musharakah Mutanaqisah Partnership (MMP) Concept

The Musharakah Mutanaqisah Partnership (MMP) contract, on the other

hand, is based on a diminishing partnership concept. The MMP consists of three

contracts – i.e. musharakah, ijarah and bay،. First, the customer enters into a

partnership (musharakah) under the concept of ‘Shirkat-al-Milk’ (joint

ownership) agreement with the bank to co-own the asset being financed.

Second, the bank leases its share in the asset ownership to the customer under

the concept of ijarah. For example, customer pays 20% of the asset cost as the

initial share to co-own the asset whilst the bank provides for the balance of

80%. Third, the customer gradually buys the bank’s 80% share at an agreed

portion periodically until the asset is fully owned by the customer. The periodic

rental amounts will be jointly shared between the customer and the bank

according to the percentage share holding at the particular times which keeps

changing as the customer purchases the financier’s share. The customer’s share

ratio would increase after each rental payment due to the periodic redemption

until eventually fully owned by the customer.

Bendjilali and Khan (1995) and Muhammad Taqi Usmani basically agreed

on the implementation process of Musharakah Mutanaqisah Partnership. The

major advantages of MMP over BBA may be summarized as follows:

1. The MMP is accepted internationally as Shari’ah-compliant whereas

the BBA is recognized predominantly in the east, i.e. in Malaysia, Indonesia,

and Brunei etc. Thus the MMP is suited for contracts across national borders.

The BBA can prove problematic for international financing applications.

2. Unlike under BBA, the value of the house under MMP always reflects

the market price and the rental is determined by the market rental values or at a

price agreed at the time of acquisition.

3. The return to the BBA is based on a fixed selling price (that uses the

prevailing interest rate as the benchmark). But under MMP, the financer need

not be tied to a fixed profit rate throughout the financing tenor. This is because

the rental rate can be revised periodically to reflect current market conditions.

Indeed, as argued earlier, the rental can be tied to some economic variables like

Rental Index, House Price Index etc. If a particular index is used, it would be

specified in the contract and acceptable to both the customer and bank to avoid

gharar.

4. The financier can manage the liquidity risks better as rental payments can

be adjusted at the end of each subcontract period. This is not possible under the

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 124

current fixed-rate BBA as the profit rate is constant throughout the entire tenor

of financing.

5. Even compared with a floating-rate BBA, the MMP still differs in the

balance of financing at any point in time before the end of the contract. Under

MMP, the balance can never be larger than the original price/finance of the

house. Rebates for early redemption under BBA cannot be specifically stated in

the contract.

6. The MMP is a more flexible financing structure than the BBA as the

customer can own the property earlier by redeeming faster the principal sum of

the financier, without the need to compute rebates(2)

as in BBA.

7. In the event of payment defaults, the penalty charges under BBA can be

challenged, while under MMP, defaults will cause the equity of financier to

remain constant and therefore entitled to higher rental portions when payments

made later.

8. If the property is auctioned(3)

off due to default, the amount sold would

depend on the highest bidder which can be lower than the balance outstanding

owed by the customer. In the case of MMP, the bank will ensure that the

property is sold at a reasonable value as a lower amount would also affect its

own position.

9. Currently many customers opine that the BBA is similar to the

conventional loan with some “disadvantages” for the customer particularly for

early redemptions.

2.1 MMP Practical Issues

In implementing the MMP the first thing that we notice is that its formula

turns out to be similar to the conventional loan. The conventional financing uses

the standard formula for present value of annuities to compute for the monthly

payments, i.e.

⎥⎦

⎤⎢⎣

⎡

+−=

n

ii

PmtPV

)1(

11 (1)

which gives, 1)1(

)1(

−+

+=

n

n

i

PViiPmt (1)’

(2) Which is at the discretion of the bank since fixing the rebate upfront is not allowed in Shari’ah.

(3) Some auction may be manipulated

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

125

Where PV = present value of the monthly or periodic installments, which is

the loan amount itself.

Pmt = the monthly or periodic installments (principal and interest).

i = the monthly or periodic interest rate.

n = the number of months or periods.

For the MMP, the monthly payment is given by the formula.

M =x(1+ x)

n

B0

(1+ x)n

−1 (2)

Where M = the monthly or periodic payments to the bank, that comprises

the rental amount and the additional amount being paid in order to redeem the

asset early.

x = rental rate, e.g. Monthly rental divided by the original asset price.

B0 = the initial contribution of the bank in the purchase price.

n = the number of months or periods for the customer to fully own the asset.

(See Appendix A)

Comparing equations (1) and (2) show a striking similarity. An obvious

advantage from this similarity is that the conventional formulas, and therefore

the conventional financial calculators and spreadsheets like Excel can be used

for the MMP computations and the preparation of amortization schedules

thereof. But the interest rate must be replaced by the rental rate, x(4).

The rental is most suited for use in Islamic finance since it is measured

from the true usufruct of the asset, unlike interest charges that are apparently not

tied to the asset’s usufruct. Hence the rental rate can differ among houses within

a same row of houses or among different floors within a condominium block.

But interest rates are generally independent from such factors.

2.2 Scholars’ opinions on using rental versus interest in MMP

In order to ascertain the validity of using actual rental value as an alternative

to interest rate, we carried out five semi-structured interviews with scholars in

Islamic economics, fiqh (law) and Shariah advisers of Islamic banks regarding

their opinion on using actual rental based on value of property for Musharakah

Mutanaqisah home financing in place of interest as a bench mark. In general,

they all agreed on the usage of actual rental value of property as an alternative

(4) Appendix C provides a worked example of using conventional calculators for solving MMP problems.

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 126

to interest rate as the former reflects the real property value in the market.

Please refer to Appendix B for detail of their opinions.

According to Taqi Usmani (2004), rental must be determined at the time of

contract for the whole period of lease. It is permissible that different amounts of

rent are fixed for different phases during the lease period, provided that the

amount of rent for each phase is specifically agreed upon at the time of affecting

a lease. If the rent for a subsequent phase of the lease period has not been

determined or has been left at the option of the lessor, the lease is not valid. This

is further supported by Wahaba al-Zuhayli (2003) which said that “A sale

without naming the price is defective and invalid “One cannot agree to buy or

rent something without knowing the price one must pay. He summarizes:

“general conditions specify that the sale must not include any of the following

six shortcomings... ‘uncertainty or ignorance (al-jahala), coercion, time-

restriction, uncertain specification (gharar al-wasf), harm (al-darar), and

corrupting conditions (al-shurut al-mufsidah)”.

Currently the practice of setting rental rates by Islamic banks in UK for

Musharakah Mutanaqisah is linked to the London Inter-bank Offered Rate

(LIBOR). Scholars have argued that setting rental levels in line with market

interest rates is not in itself haram. They argued this by analogy, on the basis

that it is permitted for a Muslim shopkeeper to make the same percentage of

profit selling lemonade as the non-Muslim shopkeeper selling alcohol (Yacuby

and Usmani, 1998).

However, we find it difficult to put this analogy to practice following the

conditions for rental mentioned by Taqi Usamani (2004) and Wahaba al-

Zuhayli (2003) because using LIBOR as a benchmark would entail uncertainty

(gharar) in the pricing of rental as it is not possible to determine future changes

in interest rates. This is because LIBOR is determined on daily basis for a

specified future period e.g. 5%p.a for 6 months, a customer would not know

what the changes in LIBOR after 6 months resulting in uncertainty in the

contract. The validity of the lease contract is further doubtful as the fixing of

subsequent rental is entirely at the option of lessor without consultation of the

lessee. As mentioned above by Taqi Usmani (2004), the lessor cannot increase

the rent unilaterally without the acceptance of the customer and any agreement

to this effect is void. If the interest rates increase dramatically, then the rental

payments will likewise increase and the customer may find himself locked into

the payment of rentals that he cannot afford causing financial burden and

hardship to himself and family which is not in line with the objective of

Shariah.

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

127

3. MMP and the Issue of Convergence

We argued earlier that the differences in the Islamic and conventional

financing would cause both financing modes to ultimately converge. Hence it is

of no surprise then that the MMP would gain popularity over the BBA since for

similar APRs, the amortization schedules for both the MMP and conventional

would look exactly the same even including the financing balances at any

period in time. Therefore, it is high time that Islamic bankers would move

towards the MMP financing. Nevertheless, a new problem is likely to arise with

respect to the convergence issue, namely the tendency to substitute the rental

rate with the market interest rate. There are a few reasons for this substitution:

1. The bank’s cost of funds is likely to be tied to market interest rates.

2. Under convergence, the use of interest rate instead of rental rate would give

an amortization schedule similar to conventional financing.

3. The interest rate is usually higher than the rental rate.

4. Tracking rentals can be cumbersome and impose additional costs particularly

if services of independent valuers are sought unless there are already national

or regional rental indices.

But a truly Islamic financing should avoid interest rates totally and let the

values and therefore payments solely be determined by the real economy. This

paper provides a solution so as to make the rental rate as robust and variable as

the market interest rate as possible.

3.1 The MMP with Variable Rental Rates

If the cost of funds to the bank is based on variable rates while the MMP

contract’s rental rate is fixed for the entire tenor, then the bank may face

liquidity risk problems as in the BBA contract. The problem is matching the

short duration deposit funds with long duration of the financings. The MMP can

be made for flexible by requiring the review of rental periodically, say every

five years. This would at least reduce the mismatch problem. An example is

provided below:

Example of a Musharakah Mutanaqisah Partnership (MMP) Financing

With Varying Rental Rate

Consider an example where a customer wishes to buy a house priced at

RM300, 000. Let’s assume that the customer pays 20 percent of the price, i.e.

RM60, 000, the financier puts the remaining 80 percent, i.e. RM240, 000. The

customer wishes to redeem the financier’s share in 20 years. Now assume that

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 128

the rental is agreed upon to be RM1, 500 per month for the first 5 years, but

would be reviewed to RM1, 800 for the next 5 years and RM2, 000 for the

remaining 10 years.

According to the MMP formulas, if the customer pays RM1, 500 only every

month, it would take more than twenty years (precisely 26 years and 11

months)(5)

to fully own the house. Therefore, some additional amount is

necessary in order to redeem within twenty years:

Here, the rental rate is, x =R

P=

1500

300000= 0.005 and the additional monthly

amount needed is

A =

x P − (1+ x)n

C0[ ]

(1+ x)n

−1

=

0.005 300,000 − (1.005)240

× 60,000[ ](1.005)

240−1

= RM219.43

Therefore, the total monthly payment = RM1, 500 + RM219.43 = RM1,

719.43 for the first 5 years (60 months).

Table (1) provides the schedule for the above MMP contract. At the end of

the 5th year, the balance of financing (financier’s equity) is RM203, 759.35

while the customer’s equity is RM96, 204.35. Thereafter, the rental would be

increased to RM1, 800 per month. The new rental rate is x = 1800/300000 =

0.6% while the remaining contract period is 15 years or 180 months. The new

additional monthly amount can be computed as follows:-

A =

x P − (1+ x)n

C0[ ]

(1+ x)n

−1

=

0.006 300,000 − (1.006)180

× 96,240.35[ ](1.006)

180−1

= RM54.31

(5) The Normal Financial Calculator can be used to solve this, i.e. PV= -240,000 i = 0.5% Pmt =

1,500 n = ?

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

129

Table 1. Payments Schedule for Musharakah Mutanaqisah Partnership With Varying

Rental Rates.

Rental Division

Month

Monthly

Rent

(RM)

Monthly

Redemption

(RM)

Total

Payment

(RM)

Customer’s

ratio Customer Financier

Customer’s

Equity (RM)

Financier’s

Equity

(RM)

Financier’s

Cashflow

(RM)

A B C=A+B D E F G H

0 0.20000 60,000.00 240,000 (240,000)

1 1500 219.43 1719.43 0.20000 300.00 1200.00 60519.43 239480.57 1719.43

2 1500 219.43 1719.43 0.20173 302.60 1197.40 61041.46 238958.54 1719.43

3 1500 219.43 1719.43 0.20347 305.21 1194.79 61566.09 238433.91 1719.43

4 1500 219.43 1719.43 0.20522 307.83 1192.17 62093.35 237906.65 1719.43

5 1500 219.43 1719.43 0.20698 310.47 1189.53 62623.25 237376.75 1719.43

6 1500 219.43 1719.43 0.20874 313.12 1186.88 63155.80 236844.20 1719.43

. . . . . . . . . .

60 1500 219.43 1719.43 0.31848 477.72 1022.28 96240.65 203759.35 1719.43

61 1800 54.31 1854.31 0.32080 577.44 1222.56 96872.40 203127.60 1854.31

62 1800 54.31 1854.31 0.32291 581.23 1218.77 97507.95 202492.05 1854.31

63 1800 54.31 1854.31 0.32503 585.05 1214.95 98147.31 201852.69 1854.31

. . . . . . . . . .

120 1800 54.31 1854.31 0.46935 844.83 955.17 141704.65 158295.35 1854.31

121 2000 -79.44 1920.56 0.47235 944.70 1055.30 142569.91 157430.09 1920.56

122 2000 -79.44 1920.56 0.47523 950.47 1049.53 143440.93 156559.07 1920.56

123 2000 -79.44 1920.56 0.47814 956.27 1043.73 144317.77 155682.23 1920.56

. . . . . . . . . .

240 2000 -79.44 1920.56 0.99364 1987.28 12.72 300000.11 -0.11* 1920.56

*Balance not zero due to rounding errors. Using the iterative method, the monthly return to the

bank is found to be 0.562337%. Therefore, the IRR = 0.562337 x 12 = 6.75%.

Therefore, the new total monthly payment = RM1, 800 + RM54.31 = RM1,

854.31 for the next 5 years (60 months). The balance of financing (financier’s

equity) at the end of this period is RM158, 295.35 while the customer’s equity

is RM141, 704.65. The customer’s ownership ratio is 47.235%. If the customer

cannot afford to pay the new rental but can only say continue to pay the old

rental, then the duration of the remaining contract period would be extended. In

the above example, if the customer continues to pay RM1,719.43 per month

instead of RM1,854.31 then the new duration of the contract becomes 17 years

and 4 months (208 months)(6)

instead of the original remaining contract period

of 15 years.

(6) Computed as PV = -203,759.35 i = 0.6% Pmt = 1,719.43 n = ?

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 130

For the remaining ten years (120 months), the rental is fixed at RM2, 000

per month, which gives a rental rate of x = 2000/300000 = 0.6667%. Now,

interestingly the new additional amount needed is a negative amount.

A =

x P − (1+ x)n

C0[ ]

(1+ x)n

−1

=

0.006667 300,000 − (1.006667)120

×141,704.65[ ](1.006667)

120−1

= −RM79.44

And therefore, the new total monthly payment = RM2, 000 – RM79.44 =

RM1, 920.56 for the last 10 years (120 months). However, if the customer is

willing to pay the RM2, 000 rental, then the remaining duration of the contract

can be shortened. In this case it would be 9 years and 5 months, i.e. shortened

by 7 months.

3.2 The MMP with Varying Property Value

The basic MMP contract is a partnership between the financier and the

customer in owning a property and then involves the renting of the property by

the customer. Periodically the customer also redeems the financier’s equity in

the said asset until it is fully owned by the customer. In the above section we

have seen how the varying rental can be accommodated for.

Some quarters nevertheless pose the question on the value of the property

too. If two parties co-own an asset and share its rental income, they should also

share the asset’s price appreciation, if any. While this may seem acceptable,

there are a few issues involved:

1. The MMP involves the redemption of the financier’s equity by the

customer. Hence by the end of the MMP contract the customer would have

acquired the full ownership of the asset and therefore any price appreciation at

that moment would fully belong to the customer.

2. An asset should be valued only when there is a sale of the property which

would involve the full transfer of ownership. Otherwise the appreciation or

depreciation of value would only be on paper(7)

. Valuation of the asset within

the duration of the MMP contract may not be appropriate since a full transfer

(7) It is like owning stocks. One need not pay taxes on stock capital gains simply because prices

have gone up until the stocks are liquidated. When stocks are sold, only then the capital gains

(losses) are realized.

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

131

does not take place at the moment of valuation. Indeed the MMP involves

gradual transfer of ownership along the entire duration of the MMP.

3. If periodic valuation of the asset, just like the rental, is agreed upon then it

should involve both appreciation and depreciation. Normally, banks do not want

to take this risk.

While we do not favour the valuation of the property during the contract

tenor, but to honor the opinion of those who think it appropriate to do so, we

provide an example for its computation. While rental can be determined

upfront, it may not be appropriate to estimate the future value of the asset

upfront. Hence valuation should be done at the times agreed upon. Let us say in

our earlier example, valuations are agreed to be done every five years and were

observed as below. Here the entire contract can be viewed as a series of four

MMP contracts.

Period

Month

Rental

RM

House Value at the end of

Period (RM)

1-60 1,500 360,000

61-120 1,800 400,000

121 – 180 2,000 440,000

181 – 240 2,000 460,000

Let us assume that at the end of the fifth year, as the rental was reviewed

from RM1,500 to RM1,800 monthly, the value of the house had appreciated to

RM360,000. At that point, the ownership ratios of the customer and the bank

were 32.08% and 67.92% respectively. Therefore, the capital appreciation

would be shared according to these ratios and the equity of the customer and the

bank would then be RM115,488 and RM244,512 respectively. At this new

value, the rental of RM1,800 per month gives a rental rate of 0.5% or 6%

yearly. The new amortization schedule would now be as given in Table (2). The

customer’s new monthly instalment is RM2,063.33 which is much higher than

the previous RM1,719.63. Computations for the rest of the period are as in the

table.

3.3 Cases of Redemption, Default and Termination of Contract

In the case of early redemption where the customer does not intend to leave

the house e.g. at end of 10 years for a 20 years tenure, the redemption amount

will be based on the balance outstanding and revaluation of property is thus not

needed. In the case of death of the partner, law of inheritance would apply and

this can be further mitigated through takaful insurance policy.

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 132

Table 2. Payments Schedule for Musharakah Mutanaqisah Partnership With

Varying Rental Rates and Periodic Asset Valuation.

Rental Division

Month

Monthly

Rent

(RM)

Monthly

Redemption

(RM)

Total Payment

(RM)

Customer’s

ratio Customer Financier

Customer’s

Equity (RM)

Financier’s

Equity (RM)

Financier’s

Cashflow

(RM)

A B C=A+B D E F G H

0 0.20000 60,000.00 240,000 (240,000)

1 1500 219.43 1719.43 0.20000 300.00 1200.00 60519.43 239480.57 1719.43

2 1500 219.43 1719.43 0.20173 302.60 1197.40 61041.46 238958.54 1719.43

3 1500 219.43 1719.43 0.20347 305.21 1194.79 61566.09 238433.91 1719.43

4 1500 219.43 1719.43 0.20522 307.83 1192.17 62093.35 237906.65 1719.43

5 1500 219.43 1719.43 0.20698 310.47 1189.53 62623.25 237376.75 1719.43

6 1500 219.43 1719.43 0.20874 313.12 1186.88 63155.80 236844.20 1719.43

. . . . . . . . . .

. . . . . . . . . .

60 1500 219.43 1719.43 0.31848 477.72 1022.28 96240.65 203759.35 1719.43

61 1800 263.33 2063.33 0.32080 577.44 1222.56 116328.77 243671.23 2063.33

62 1800 263.33 2063.33 0.32314 581.64 1218.36 117173.74 242826.26 2063.33

63 1800 263.33 2063.33 0.32548 585.87 1214.13 118022.94 241977.06 2063.33

. . . . . . . . . .

. . . . . . . . . .

120 1800 263.33 2063.33 0.48061 865.10 934.90 174148.55 185851.45 2063.33

121 2000 292.57 2292.57 0.48375 967.50 1032.50 194760.07 205239.93 2292.57

122 2000 292.57 2292.57 0.48690 973.80 1026.20 196026.44 203973.56 2292.57

123 2000 292.57 2292.57 0.49007 980.13 1019.87 197299.14 202700.86 2292.57

. . . . . . . . . .

. . . . . . . . . .

150 2000 292.57 2292.57 0.58180 1163.59 836.41 234175.08 165824.92 2292.57

151 2000 292.57 2292.57 0.58544 1170.88 829.12 235638.53 164361.47 2292.57

. . . . . . . . . .

. . . . . . . . . .

180 2000 292.57 2292.57 0.69931 1398.62 601.38 281415.12 118584.88 2292.57

181 2000 488.87 2488.87 0.70354 1407.08 592.92 311453.35 128546.65 2488.87

182 2000 488.87 2488.87 0.70785 1415.70 584.30 313357.92 126642.08 2488.87

183 2000 488.87 2488.87 0.71218 1424.35 575.65 315271.14 124728.86 2488.87

. . . . . . . . . .

. . . . . . . . . .

240 2000 488.87 2488.87 0.99437 1988.74 11.26 440000.04 -0.04* 2488.87

*Balance not zero due to rounding errors.

Using the iterative method, the monthly return to the bank is found to be 0.671594%

Therefore, the IRR = 0.671594 x 12 = 8.0591%

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

133

A revaluation of the property would take place when the customer intends to

leave the house. The revaluation price will be used to offset the outstanding

amount and the residual amount will be shared between the customer and the

bank based on the prevailing profit sharing ratio. Like wise in cases of default,

the house will be sold in the market and the proceeds will be divided between

the customer and the bank after deducting all outstanding arrears, liquidation

costs including legal costs etc.

Let us assume that the customer defaults after making the 150th monthly

rental. At that point the customer’s and bank’s equity ratios in the house are

58.544% and 41.456% respectively. Also assume that at that point, the market

price of the house is RM420,000. Therefore, the customer’s and bank’s portions

are RM245,884.80 and RM174,115.20 respectively. But of course, before this

division, liquidation costs should have been deducted first. The IRR for the

bank in this case (assuming zero liquidation costs) is 8.3%. The higher figure is

due to the price appreciation.

In the event of default, any arrears in rental due from customer should also

be deducted before the customer’s portion is rendered. Rental arrears should

also be calculated based on the above ratios. For example if the customer

defaulted on three months’ rental totaling RM6,000 then the bank’s portion in it

is RM2,487.36 (i.e. RM6,000 x 0.41456) and this amount should be deducted

before the remainder of the customer’s portion in the selling price and the

balance is returned to the customer.

4. Estimating the New Rental

From the above example it is obvious that the MMP formulas can be easily

adapted for use in varying rental rates. But estimating the rental is what could

prove cumbersome or costly. Some MMP operators use the services of

independent real estate agents to provide them with the estimates; sometimes

using average of as many as three agents’ estimates in order to be more just. But

all these can impose additional cost on bank and the customer.

This paper suggests the use of rental indices or house price indices in order

to estimate the new rentals without having to bear the cost of using the services

of real estate agents. Nonetheless, using indices would cause the loss of some

accuracy. Prices and rental of real estate properties are sensitive to many

factors. Even within the same locality, particular location can affect prices and

rentals. Other than characteristics of the property like floor size, number of

rooms, single storey or double storey, corner or intermediate etc., its location

relative to school, shops, LRT, hospital, mosque, sewage etc can also affect

prices and rentals, (Dunse and Jones, 1998). While an index may give the

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 134

average rental in a locality, specific factors like those mentioned should also be

taken into consideration in order to get a better rental estimate fair to both sides.

4.1 Estimating the Rental Rate

This section looks at the empirical data from selected areas in Malaysia

regarding rental rates and interest rates and attempts to come up with a

regression model for estimating rental rates. Such models can then be used for

obtaining rental rates to be used in the MMP computations without having to

employ the services of property valuers.

Table (3) provides the average gross rental yields and the interest rates for

properties in Kuala Lumpur for the period 1984 to 2005. It is clear from the

Table that the rental yields for all categories of houses are generally lower than

the BLR and the average lending rate. Only condominiums have shown to fetch

higher rental yields than the market interest rates. The average differences of the

rental yields compared to the average lending rates are provided in Table (4).

The lending rate is on average a substantial 4.49%, 4.65% and 4.10% higher

than the rental yields for single storey, double storey and double storey semi-

detached houses respectively. Nonetheless, interestingly the rental yields for

condominiums were higher than both the BLR and the average lending rate. The

condominiums rental yield was on average 1.08% and 2.10% higher than the

average lending rate and BLR respectively.

An analysis of the correlation matrix in Table (5) between the variables

shows some interesting results. Firstly, the interest rates are positively

correlated only with the yields of higher end properties, i.e. double storey semi-

detached and condominiums. Interestingly, the interest rates were negatively

correlated to the yields of single storey and double storey houses. Other than the

BLR which is also an interest rate, the average lending rate is the highest

correlated with the yields of condominiums with a correlation of 0.5219. It

seems that investors in only the higher end properties adjust the rental in

accordance with the changes in the market interest rate.

5. Conclusion

This paper pointed out some practical issues that need to be addressed with

the implementation of MMP particularly that affect changes in rental rates;

revaluation of property; redemption, defaults, termination of contract and

proposed solutions in dealing with these situations.

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

135

Table 3. Gross Rental Yields and Interest Rates Kuala Lumpur.

Average

Year Storey Lending rate

Double

Storey

Double Storey

Semi-D Condominium BLR

1984 3,87% 4,07% 4,32% . 12,25% 12,80%

1985 3,75% 4,17% 4,47% . 10,75% 12,10%

1986 5,23% 3,44% 3,97% . 10,00% 12,02%

1987 4,77% 5,23% 5,21% 14,55% 7,50% 9,73%

1988 5,01% 4,78% 5,50% 8,98% 7,00% 8,95%

1989 5,01% 4,78% 5,50% 8,98% 6,99% 8,70%

1990 5,01% 4,78% 5,50% 8,98% 7,49% 8,99%

1991 4,85% 4,53% 6,00% 10,50% 8,68% 9,72%

1992 4,90% 4,56% 7,95% 10,73% 9,29% 10,29%

1993 5,40% 5,26% 8,35% 10,56% 8,22% 9,65%

1994 5,44% 5,48% 6,95% 9,13% 6,83% 8,24%

1995 4,70% 4,81% 6,80% 11,02% 8,03% 9,28%

1996 3,24% 3,70% 4,70% 10,40% 9,18% 10,12%

1997 3,24% 3,70% 4,70% 8,89% 10,33% 11,51%

1998 4,52% 4,30% 3,50% 8,89% 8,04% 9,72%

1999 4,66% 4,26% 4,50% 9,02% 6,79% 7,75%

2000 4,66% 4,26% 4,50% 9,02% 6,78% 7,46%

2001 4,95% 4,03% 3,40% 9,05% 6,39% 6,67%

2002 4,95% 4,03% 3,40% 9,05% 6,39% 6,51%

2003 3,80% 4,07% 3,00% 8,24% 6,00% 6,11%

2004 3,80% 4,07% 3,00% 8,24% 5,98% 5,98%

2005 3,95% 3,82% 3,00% 7,81% 6,20% 6,12%

Average 4,53% 4,37% 4,92% 9,58% 7,96% 9,02%

Std

Deviation 0,66% 0,54% 1,55% 1,50% 1,72% 2,03%

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 136

Table 4. Differences between Average Lending Rates and Gross Rental Yields

Kuala Lumpur.

Year Single

Storey

Double

Storey

Double

Storey

Semi-D

Condominium ALR minus

BLR

BLR minus

Condo Rental

Yield

1984 8,93% 8,73% 8,48% . 0,55%

1985 8,35% 7,93% 7,63% . 1,35%

1986 6,79% 8,58% 8,05% . 2,02%

1987 4,96% 4,50% 4,52% -4,82% 2,23% -7,05%

1988 3,94% 4,17% 3,45% -0,03% 1,95% -1,98%

1989 3,69% 3,92% 3,20% -0,28% 1,71% -1,99%

1990 3,98% 4,21% 3,49% 0,01% 1,50% -1,49%

1991 4,87% 5,19% 3,72% -0,78% 1,04% -1,82%

1992 5,39% 5,73% 2,34% -0,44% 1,00% -1,44%

1993 4,25% 4,39% 1,30% -0,91% 1,43% -2,34%

1994 2,80% 2,76% 1,29% -0,89% 1,41% -2,30%

1995 4,58% 4,47% 2,48% -1,74% 1,25% -2,99%

1996 6,88% 6,42% 5,42% -0,28% 0,94% -1,22%

1997 8,27% 7,81% 6,81% 2,62% 1,18% 1,44%

1998 5,20% 5,42% 6,22% 0,83% 1,68% -0,85%

1999 3,09% 3,49% 3,25% -1,27% 0,96% -2,23%

2000 2,80% 3,20% 2,96% -1,56% 0,68% -2,24%

2001 1,72% 2,64% 3,27% -2,38% 0,28% -2,66%

2002 1,56% 2,48% 3,11% -2,54% 0,12% -2,66%

2003 2,31% 2,04% 3,11% -2,13% 0,11% -2,24%

2004 2,18% 1,91% 2,98% -2,26% 0,00% -2,26%

2005 2,17% 2,30% 3,12% -1,69% -0,08% -1,61%

Average 4,49% 4,65% 4,10% -1,08% 1,06% -2,10%

Std

Deviation 2,21% 2,12% 2,08% 1,54% 0,68% 1,53%

Table 5. The Correlation Matrix between the Rental Yields and Interest Rates.

SS DS DSSD Condo BLR ALR

SS 1

DS 0.615952869 1

DSSD 0.495512227 0.721509033 1

Condo 0.223357253 0.497778003 0.484285081 1

BLR -0.304341179 -0.239105695 0.215673069 0.387622296 1

ALR -0.116503069 -0.044759391 0.347073901 0.521904316 0.947458002 1

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

137

We have shown that increase in rental rates would reduce the additional

share to be acquired by the customer in subsequent years. If the customer cannot

afford to pay the new rental and choose to continue paying the old rental, the

duration of the remaining contract would be extended. As mentioned, we do not

favour periodic revaluation of property over the tenure as we are of the view

that asset revaluation should take place when there is a sale incurring full

transfer of property ownership. With regards to redemption, defaults and

termination of contract, a revaluation decision would depend on the situations.

The property need not be revalued if the customer does not intend to leave the

house as the redemption amount would be the same as the balance outstanding.

The property would be revalued when the customer intends to leave the house

and in cases of default and termination of contract as this would involve the sale

of the property. The residual amount will be shared between the customer and

the bank after deducting all outstanding arrears, liquidation costs including legal

costs etc. based on the prevailing profit sharing ratio.

This paper also made a comparison between interest rates and average gross

rental yields for properties in Kuala Lumpur for period 1984 to 2005 whereby it

was seen that rental yields for all categories of houses are generally lower than

BLR and average lending rate. Only condominiums have shown higher rental

yields than market interest rates. This implies that the bank may use MMP for

properties that have potential of high rental only. When not feasible, for the

bank when rental rates fall short of interest rates, the MMP model can be

implemented through cooperatives, as an investment avenue to address the

social well being of its members.

References

Bendjilali, Boualem and Khan, Tariqullah (1995) Economics of Diminishing Musharakah.

Research Paper No. 31.Jeddah: Islamic Research and Training Institute (IRTI), IDB.

Dunse, Neil and Jones, Colin (1998) " A Hedonic Price Model of Office Rents", Journal of

Property Valuation and Investment, 16(1): 297-312.

ISRA Monograph Series: 1(2009) International Shariah Research Academy for Islamic Finance

(ISRA).

Meera, Ahamed Kameel Mydin and Abdul Razak, Dzuljastri (2005) “Islamic Home Financing

through Musharakah Mutanaqisah and Al-Bay’ Bithaman Ajil Contracts: A Comparative

Analysis”, Review of Islamic Economics, 9(2): 5-30.

Usmani, Muhammad Taqi (2004) An Introduction To Islamic Finance, Maktab Maa’rul Quran,

Karachi-Pakistan.

Yacuby, Shaikh Nizam and Usmani, Muhammad Taqi Usmani (1998) “Fatwa on Usage of

LIBOR as a Benchmark”. A Fatwa issued on 19 July.

al-Zuhayli, Wahaba (2003) Islamic Jurisprudence and Its Proofs, Dar al-Fikr, p. 33; 56.

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 138

Appendix (A)

Musharakah Mutanaqisah Partnership

Computational Example

Meera and Abdul Razak (2005) derived the formulas for the MMP as follows:

P = Price of asset, e.g. a home

B0 = Financier’s contribution into the partnership

C0 = Customer’s contribution into the partnership

Therefore, 00

CBP +=

R = Periodic rental, e.g. monthly

A = Additional periodic payment by customer to redeem the financier’s equity faster

M = R + A, is therefore, the total periodic payment

Let i

C = the customer’s equity (ownership) of the asset in period i

Let the proportion of customer’s equity in period i, P

Cr

i

i=

Ax

xCxC

n

n

n ⎥⎦

⎤⎢⎣

⎡ −+++=

1)1()1(

0 (1)

and, of course, the proportion of the customer’s equity in the nth period is P

Cr

n

n=

Rewriting equation (1), the number of periods taken by the customer to fully own

the house is given by,

)1ln(

lnln0

x

x

AC

x

AP

n+

⎟⎠

⎞⎜⎝

⎛+−⎟

⎠

⎞⎜⎝

⎛+

=⇒ (2)

Once the rental, R, has been determined and the customer has decided on the period

of partnership, i.e. the n, then the periodic amount the customer has to top up

additionally is given by

[ ]1)1(

)1(0

−+

+−

=n

n

x

CxPxA (3)

and, the formula for determining the periodic payment is given by

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

139

1)1(

)1(0

−+

+

=⇒n

n

x

BxxM (4)

The periodic rate of return for Mushārakah Mutanākisah Partnership is solely

determined by the rental rate, P

Rx = . Therefore, the

Internal Rate of Return (IRR) to bank P

R= (5)

Also,

Total payment made to financier = Mn (6)

Total profit to financier = 0

BMn − (7)

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 140

Appendix (B)

Below are the summary of five semi-structured interviews with scholars in Islamic

economics, fiqh (law) and Shariah advisers of Islamic banks regarding their opinion on

using actual rental based on value of property for Musharakah Mutanaqisah home

financing in place of interest as a bench mark.

Question:

“ What is your opinion on using actual rental value of property for

Musharakah Mutanaqisah home financing in place of interest as bench mark?"

Respondent 1

Using bench mark on property is a plus point for Musharakah Mutanaqisah

home financing as it reflects the real value of property. But we must also ensure

that the property market is not manipulated to ensure fairness to both parties

Respondent 2

Using rental based on actual value of property is better because it reflects

the real market compared to interest rate. However we must ensure fairness to

both parties. Currently, we are sill benchmarking against interest rate. We need

to change our mind set.

Respondent 3

Yes, bank as far as possible should use rental based on the actual value of

property to avoid interest. However interest rate can still be used as a point of

reference only. It's best for both bank and customer to agree on whatever bench

mark (interest or actual value of property) to be used. I would suggest that bank

fixed upper and lower pricing limit as an alternative to interest rate which

fluctuates dramatically”.

Respondent 4

Pricing should be based on the market. Currently, we can use interest rate

as a point of reference in the absence of an Islamic benchmark. However, we

should be working towards our own benchmark which is free from interest.

Respondent 5

We should base as far as possible pricing to reflect the market. As in

property, we should price rent following the demand and supply of house within

the area. There should also be bargaining allowed between the lessor and

lessee before the amount of rent is agreed upon.

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

141

Appendix (C)

Using Conventional Calculators for MMP: A Worked Example

Price of House = RM200,000

Rent = RM1,000 per month

Conventional Mortgage & BBA Musharakah Mutanaqisah

APR = 10%

Downpayment = RM20,000 (10%)

Loan OR Financing = RM180,000 (90%)

Duration = 20 Years monthly payments

In conventional mortgage the Present Value of

Annuities formula is used:

PV =Pmt

i1−

1

1+ i( )n

⎡

⎣ ⎢ ⎢

⎤

⎦ ⎥ ⎥

The monthly interest rate,

i =10%

12= 0.8333% = 0.008333

i.e. 180,000 =

Pmt

0.0083331−

1

1.008333( )240

⎡

⎣ ⎢ ⎢

⎤

⎦ ⎥ ⎥

⇒ Pmt = RM1,737.03 per month

Using Finance Calculator:

PV = -180,000 i = 0.8333% n = 240 Pmt = ?

Total payments = RM1,737.03 X 240

= RM416,889.35

Total interest = RM416,889.35 – 180,000

= RM236,889.35

(Which is total profit under BBA)

Initial Contribution of customer = RM20,000 (10%)

Initial Contribution of financier = RM180,000 (90%)

Rental rate, x

P=

1,000

200,000= 0.5% per month

Duration = 20 Years monthly payments

In order to redeem the financier’s share within 20

years, the customer has to pay additional amount, A,

per month over and above the rental [Equation 3]

A =

x P − (1+ x)n

C0[ ]

(1+ x)n

−1

=

0.005 200,000 − (1.005)240

× 20,000[ ](1.005)

240−1

= RM289.58

Total monthly payment =

RM1000 + RM289.58 = RM1,289.58

Since the mathematical derivation showed that the

formula for MM is similar to those of conventional

and BBA but interest rate replaced with rental rate, we

can also solve the above as follows:

180,000 =Pmt

0.0051−

1

1.005( )240

⎡

⎣ ⎢ ⎢

⎤

⎦ ⎥ ⎥

⇒ Pmt = RM1,289.58 per month

Using Finance Calculator:

PV = -180,000 i = 0.5% n = 240 Pmt = ?

Since the monthly rent is RM1,000, then the additional

amount needed is, therefore, RM289.58

Ahamed Kameel Mydin Meera and Dzuljastri Abdul Razak 142

Balance after 10 years (120 payments)

Under Conventional

Balance =1,737.03

0.0083331−

1

1.008333( )120

⎡

⎣ ⎢ ⎢

⎤

⎦ ⎥ ⎥

= RM131,443.76

Using Finance Calculator:

i = 0.8333% Pmt = 1,737.03 n = 120 PV = ?

Under BBA

The balance is simply the monthly payment

times the number of months

Balance = RM1,737.03 X 120

= RM208,444.66

Balance after 10 years (240 payments), i.e. the

financier’s equity in the house

Under MM

Balance =1,289.58

0.0051−

1

1.005( )120

⎡

⎣ ⎢ ⎢

⎤

⎦ ⎥ ⎥

= RM116,156.56

Using Finance Calculator:

i = 0.5% Pmt = 1,289.58 n = 120 PV = ?

If customer wants to own the home in 15 years, i.e.

180 months, then

180,000 =Pmt

0.0051−

1

1.005( )180

⎡

⎣ ⎢ ⎢

⎤

⎦ ⎥ ⎥

⇒ Pmt = RM1,518.94 per month

i.e. an additional monthly amount of RM518.94 is

needed.

Using Finance Calculator:

PV = -180,000 i = 0.5% n = 180 Pmt = ?

If the customer pays RM1,737.03 as in the BBA

example, he could own the house even faster, i.e.

[Equation 2]

n =

ln P +A

x

⎛

⎝ ⎜

⎞

⎠ ⎟ − ln C

0+A

x

⎛

⎝ ⎜

⎞

⎠ ⎟

ln(1+ x)

=ln 200,000 +147,406( )− ln 20,000 +147,406( )

ln 1.005( )

=146.38 =147 months

i.e. 12 years 3 months.

Using Finance Calculator:

PV = -180,000 i = 0.5% Pmt = 1,737.03 n = ?

Home Financing through the Musharakah Mutanaqisah Contracts: Some Practical Issues

143

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